Bob Litterman, Kepos Capital, on Market Efficiency and the Climate Risk Premia Gap

How efficient are markets at pricing climate risk? Listen to Jason Mitchell discuss with Bob Litterman, Kepos Capital, about how climate risk thinking has advanced since our last podcast; what evolving market, policy, and pricing signals reveal about the true cost of climate uncertainty; and why the pullback in regulation and net zero could actually lead to more a rigorous focus on understanding climate risk rather than reporting.

Recording date: 02 December 2025

Bob Litterman

Bob Litterman is the founding partner of Kepos Capital and former head of risk at Goldman Sachs, where he co-developed the Black-Litterman model—one of the most widely used asset allocation frameworks in the world. Over the past decade, he’s become a leading advocate for pricing climate risk correctly, serving as chair of the CFTC’s Climate-Related Market Risk Subcommittee and helping shape how regulators and investors think about the financial system’s exposure to climate change. Bob currently chairs the Climate-related Financial and Macroeconomic Risk Initiative, a joint effort by Havard University’s Salata Institute for Climate and Sustainability and Resources for the Future. He also serves on the Advisory Council of the Natural Capital Project, part of the Doerr School of Sustainability at Stanford University, the boards of Ceres and the Niskanen Center as well as co-chair of the Climate Leadership Council.

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Jason Mitchell:

Welcome to the podcast, Bob Litterman. It's great to have you here and thank you for taking the time today.

Bob Litterman:

Thanks, Jason. It's great to be here, and I look forward to the conversation.

Jason Mitchell:

Absolutely, absolutely.

Bob, a lot has changed and not changed so much since we recorded our first podcast way back in 2019. Back then, we talked about how economic models didn't really address climate change and why a carbon price is a vital signal for understanding climate risk. When you look back, how do you reflect back on, I guess, progress in some areas and the lack of progress in others? And more specifically, to what degree has your view of imposing a price on climate risk had to essentially recalibrate given the uncertainty, not just in carbon pricing, but of climate policy more generally?

Bob Litterman:

Thanks, Jason. That's a great question. I think the main thing that has changed is we've lost time. We haven't gotten started on pricing climate risk, and therefore we don't have the right incentives in place, we don't have enough investment going into solutions to reducing emissions. Time is a scarce resource when you're managing risk, and we're trying to manage risk here and we've lost time. That's the most important thing that's changed.

You could think about it in terms of the reservoir that we have for future emissions. We've been filling that reservoir up, and so there's just a lot less room today. We haven't started pricing. I think most investors, most entrepreneurs do not expect to get compensated for reducing emissions in the future, and that's why the investment has been too low. That's why we're moving too slowly toward net zero, and that just means that the risk is increasing over time.

Jason Mitchell:

Interesting, but I want to stick on that point, so can you maybe talk about how you recalibrate the kind of framework of thinking that you were operating on six years ago?

Bob Litterman:

Yeah. Six years ago, there was a hope that the UN process would be successful. That was, in retrospect, a mistaken hope. The UN process requires unanimity, and it's very clear that for some countries, it's not in their interest to move forward quickly, and so they've been blocking progress. That continued up through the most recent COP just last month in Belém. I think people have lost hope. The US has dropped out of the UN process, so there's a lot less, I think, hope that the UN process can succeed. People are looking for other approaches.

I chair the Climate Leadership Council, which six years ago was looking for support for a carbon dividend plan, a pricing mechanism in the United States. Today at the Climate Leadership Council, we're focused on climate and trade. I think that's where the frontline of climate policy is today. And in some ways that's a good thing, but I don't think anyone is very optimistic that there is going to be global significant, I would say, appropriate incentives to reduce emissions. And that's very sad.

Six years in this context is a lot of time to lose. And it means that the ultimate temperature is going to be that much higher, probably something like two tenths of a degree higher than would have been possible had we gotten started six years ago. And every year that goes by is another wasted opportunity. It's another way to create additional risk for our grandchildren. So, we haven't made progress. What does that mean for investors?

I think it means that they've been moving away from what were ineffective approaches, screening for fossil fuels or divesting or looking at other ESG metrics and are rather now much more focused on climate risk as a risk factor and the implications for the assets in their portfolio. Physical risk is starting to get larger and larger over time. And the longer we delay policies that create incentives to reduce emissions, the more likely it is that that policy is going to be imposed in a disruptive way. That scenario of disruptive response is more likely and is a bigger risk, call that transition risk than it was six years ago.

Jason Mitchell:

That's a really good backdrop to jump into this. We're definitely going to revisit physical risk, for sure. I want to dig in a little bit more about how investors' approaches have changed.

How do you think markets and investors have evolved in terms of their sophistication, understanding specifically climate risk as a risk premium, rather than just a broad ESG overlay or a set of carbon constraints? What role does uncertainty in global climate policy coordination play in determining risk premia?

Bob Litterman:

That's exactly right. It is, in fact, the uncertainty about policy that creates, I would call it, a systemic risk factor. And that systemic risk factor is really the immediate creation of appropriate incentives to reduce emissions, the waking up and coordination of global policy. And I actually see that as increasing significantly in the last six years, in particular because, as I mentioned, the reservoir for safe emissions into the atmosphere has basically been used up. It's really too late.

We should have gotten started a long time ago and then we wouldn't have the same risk that we have today, but because we've put it off... Everyone knows where we're going. We're going to go to a low carbon economy. We're going to have to. The question is how we get there. And rather than that be a relatively smooth evolution, what's going to happen is that the powers that be are going to realise, no, this is an existential threat to the wellbeing of future generations.

There's tremendous uncertainty and we have to address that uncertainty. And when we do, when we price that risk, it's going to be a fundamental change. Because we're not talking about small incentives, we're talking about a slam-on-the-brakes scenario, which means an appropriately high price. The social cost of carbon, the price that we ought to be paying, the estimates of that have increased dramatically.

I did some work six years ago with some colleagues where we estimated... We called it a base case of $120 or so per tonne of carbon. The US government is already close to $200 a tonne. I think the estimates have definitely gone up. I would say probably 200 is a reasonable estimate of where we ought to be. And if you look at the average incentive globally to reduce emissions, it's an order of magnitude lower than that at least, maybe in the teens. There's a lot of countries around the world that are still subsidising fossil fuels and thus have negative incentives, if you will, to reduce emissions.

Investors, I think, are becoming more aware of that transition risk that is a systemic risk. It'll have impacts throughout the economy, particularly of course in the fossil fuel sector. But the other thing it'll do is it'll incentivize investment. Right now, given the low expectations for pricing risk anytime in the near future, what you've basically got is government subsidies and nonprofits investing in low carbon. But you don't have the private sector investing anywhere near where it needs to, and thus you don't have enough investment.

Bloomberg New Energy Finance estimates that maybe we're at 30 or 40% of where we need to be in terms of the annual investments. So, we're not moving quickly enough to a low carbon economy. That's the bottom line. And the risk to investors is that globally we start to move much faster, which is the appropriate speed. We really need to dramatically speed up the response. And that uncertainty about when and how that happens is really the major risk facing investors in the climate space.

In addition, as we've discussed, you also have physical risk. And that physical risk is something that investors have to look at. In different regions, it's going to be a different risk. Whether you're on the coast of the Atlantic or in the middle of the United States or in Europe or in Africa, each region is going to have its own physical risks, and investors are going to have to be cognizant of whether the investments they make in those areas are resilient to the climate-related hazards that they face.

One of the things that I think most people are a little bit naive about is all the different dimensions of these climate hazards. You've basically got more energy, both in the oceans especially, and also in the atmosphere and so you see heavier downpours, you see sea level rise and hurricanes, you see droughts and heat waves that cause wildfires. You even have more energy causing colder cold waves and so on. It's really a thickening of the tails of the distributions.

Everyone's heard of the 100-year flood. What some people don't realise is that that 100-year flood is no longer a statement about the frequency. It's a statement about the magnitude. What used to be a flood that happened once in 100 years, and therefore you were unlikely to experience it over any one lifetime, the building codes aren't ready for it, and historically it would wipe out investments in that area where it flooded. Today, that 100-year flood may be happening much more frequently. It will be happening more frequently. Maybe it's every 10 years or every five years. That's the flood.

Same thing as true about heat waves or droughts or sea-level rise. Sea-level rise is a little bit different because it's chronic. But the hurricanes are going to be bigger because they strengthen faster over warmer water, and we've been seeing that in recent years. And the tornadoes are bigger and the droughts are lasting longer and so on. So, when you think about physical risk, you have to think about which climate-related dimensions are we talking about? Are we able able to handle that or not? And where are my assets located?

And also, are those risks going to be compounded by correlation with other risks? In Los Angeles, we had the fires. Then if you have heavy rains, you're going to get additional flooding and so on. So-

Jason Mitchell:

Let me stop you for a second.

Bob Litterman:

Sure.

Jason Mitchell:

I guess one question... This is a great topic, but I guess I wonder... why does it seem like insurers are the only ones really examining, call it, the relationship between asset pricing and a company's resilience to different individual physical risks? As you said, we have current earth observations across many acute and chronic hazards and perils, we have geospatial data.

Why do you think the market isn't doing more work to understand the existing impact of hazards like extreme heat, extreme precip, water scarcity, and primary perils like hurricanes, or secondary perils on asset pricing and portfolio returns? I don't see that, particularly in the listed market.

Bob Litterman:

You're right to focus first on insurance. Insurance is certainly the frontline of climate impacts. And the insurers are experts in managing risk, so they've been managing their risk very well by pulling back. They have identified risky areas. One of the statistics I heard was that 40% of the houses in the areas that were burned in Los Angeles had lost their insurance in recent years because the insurers had pulled back. They saw what was coming.

Your question is, why don't investors in the same way start building risk premia into assets? And I think the answer is they are starting to do so. You're starting to see, for example, housing in high-risk areas is either unable to get insurance or the insurance is more expensive. And what that means is the value of the house is lower because the cost of maintaining it is higher. You're starting to see those kinds of impacts on housing and similarly on other infrastructure that is in high-risk areas.

I think you're starting to see it built in, but you're right to suggest that it certainly hasn't been fully built in to the prices of assets.

Jason Mitchell:

I do wonder, I mean, per this point, institutional investors tend to think about climate change, I think generally as an exercise in risk management, and that... In this discussion around climate risk, that tends to mean stress-testing portfolio 25 to 30 years out based on IPCCC or NGFS scenarios. That means a lot of debate around the right discount rate, all these assumptions going into these models. And it feels like that exercise... While it's obviously very important in understanding that risk for portfolios, it feels like it sucks a lot of the oxygen out of the discussion.

I guess I'm trying to think temporally, because as we talked about, we're already seeing weather impacts occurring in the short term and, as you said, risk premium begin to emerge. How do you think about bridging those two points temporally, this long-term, stress-testing exercise and this short term, one to three year... The insurers are pricing that as well... and bridging those two points through some sort of asset allocation framework?

Bob Litterman:

Let's start with those 30-year type exercises. That's something that the government needs to worry about. It's government policy that will address the risk of climate impacts 30 years from now. That's not the problem that investors have. Remember that investors are going to rebalance their portfolios over time. They're not buying a portfolio today to hold it for 30 years. What investors have to worry about is the returns and the risk over relatively shorter periods of time.

For instance, if you own fossil fuel companies, it's not the climate of 30 years from now that you're worried about. You're worried about what's going to happen to these companies over the next shorter period of time. And that requires you to think about where are we in terms of the policy cycle. If you go back to 2013, I think it was that the World Wildlife Fund started worrying about fossil fuel assets in its portfolio, and we got rid of those assets in various ways. We hedged out that risk. For the next seven years or eight years, until the COVID occurred, or the pandemic, I mean, the fossil fuel assets underperformed. They basically didn't appreciate at all while the market itself doubled in value, and so there was an under-performance there.

But since the COVID pandemic, those fossil fuel assets have outperformed, at least until recently. And as an investor, it's those shorter-term impacts that you're going to be thinking about. And as it relates to fossil fuel assets, you would expect them to be further exposed to the potential for pricing of carbon. And therefore you'd expect them to have to have a higher risk premium, which means start at a lower price. Maybe that seven year decline was the revaluation of fossil fuel assets to a point where they're achieving a higher return today.

You have to think about where you are in that cycle and how are those assets going to react to the risk? It's not obvious that you need to divest of those fossil fuels. Maybe you're getting paid an appropriate higher premium that is appropriate for the risk that they face today. You can rebalance your portfolio five years from now if you decide that things have changed.

Jason Mitchell:

Yeah, it's interesting. I'm still thinking about the physical risk conundrum.

Bob Litterman:

Physical risk is different.

Jason Mitchell:

I realise that from our last conversation, but I guess I wanted to get your view. To me, it seems like the market, and I'm thinking in a listed sense, is operating around two dominant narratives.

The first one is, who are the winners? Who are the solution providers in a warming world? The company's producing air conditioners or generators, given the increase in physical risk. And that, it's interesting, but let's face it, every investment bank has probably already produced a thematic basket around that type of strategy. And the other dominant narrative seems to be financing or funding adaptation, which is interesting because that describes... That feels very [inaudible 00:22:23] fans-ish. It describes more steering capital to solve a problem. If investors have that mandate, so be it.

But I think what's missing, and I think you might agree, is we talk about pricing carbon, why aren't we talking about pricing resilience or adaptation? That seems to be missing in the market more broadly, again, outside of the insurers.

Bob Litterman:

I agree with you, but like you say, outside of insurance. Insurers are already motivating resilience, adaptation, planning. They're asking homeowners to cut down the vegetation within five feet of their house, et cetera. I think that those kinds of actions more generally by corporations to make their own infrastructure resilient will be rewarded. So, I agree with you.

Whether that's already built in or not, as you point out, and I would agree, the investment banks are already doing a lot of research along these lines. And for investors who are interested, there certainly is plenty of information out there. And I think more and more investors are going to have to be interested because they're going to be seeing these impacts on their investments.

Jason Mitchell:

Yeah, I agree. I wanted to change lanes a little bit. There seems to be, at least in listed markets again, this really interesting struggle in distinguishing real-world impact from portfolio exposure in the climate space. A number of academics have observed this, Hartzmark and the Shue paper, Counterproductive Sustainable Investing. There's one more recently called Climate Capitalists as well.

How do you balance real-world impact in the words of reduction in financed emissions against a more traditional view focused on risk-adjusted returns in a portfolio's, I would say, net carbon exposure? Are these two objectives, returns and impact, compatible?

Bob Litterman:

It's a great question. A lot of investors want to have impact. The truth of the matter is this is a problem for governments. We are not going to solve the problem until we create appropriate incentives to reduce emissions. And when I say solve the problem, I mean create appropriate amounts of private sector investment in low carbon solutions. That's not happening. And there's no way that the type of impact investing that we've seen historically is going to have the kind of impact that we need. It's just not reasonable to think that investors are going to solve this problem on their own. The most important thing investors can do is to support appropriate pricing of emissions. And once there's appropriate incentives, then entrepreneurs, investors, consumers, everyone will be moving in the right direction. It's the invisible hand without even thinking about it or worrying about it.

And in the meantime, no, impact investing is not going to solve the problem. It's not even going to make a dent in the problem. And people should just recognise that. They should worry about creating the prerequisites that will allow for governments to do the appropriate thing. And I would say that there are many governments. In fact, probably most governments around the world recognise the reality now of what's happening and are moving quickly. China is a great example, where they have moved rapidly in the direction of creating a low carbon economy and manufacturing batteries, electric vehicles, wind, solar, and supplying those around the world.

There's many, many countries, developing countries that have not yet built a big fossil fuel infrastructure that are just going to go directly to renewable sources of energy. And what you're going to see, I think going forward, is a bifurcation of countries into those who are moving quickly to a low carbon economy, and which will definitely set up appropriate tariffs on high carbon imports. Europe has already done this. At the Brazil COP, you saw a whole bunch of countries, including Brazil, China, Mexico, Canada, the European Union all say, "We're going to price carbon and we're going to create tariffs against countries that are not pricing carbon." What that does is it creates an incentive on countries that are not part of that group to join that group. So, if you're Japan or Australia and you're not in the initial group of countries that create prices and tariffs, then you basically have a decision. Am I going to price carbon and create a tariff and thereby keep the revenues from that tax or am I going to not do it and then all of my exports are going to be taxed by the importing country and they'll keep the revenues? It creates an incentive for all those countries to then join and that will create ultimately the pathway toward global pricing of emissions.

When that happens is certainly unclear, but it also seems like it's inevitable that that's going to happen. And that's how we're going to solve this problem, not through investors trying to have impacts. That's just wasting time as far as I'm concerned.

Jason Mitchell:

We talked around this a little bit earlier. What do you think an economically correct carbon price looks like today? And what signals would we see in markets if the price were right? I'm not naive. I know the policy environment never really allowed for it, but what blind spots do you see in how investors model carbon-pricing pathways?

Bob Litterman:

As I said before, the appropriate price is a very high price. It's hard to know. There's tremendous uncertainty about what that price is and then how you react to that uncertainty, I would say you have to be cautious. If we don't know whether the right price for carbon is $100 a tonne or $200 a tonne, where do you want to end up? You probably want to end up on the safe side. I mean, this is all about risk management for our children and our grandchildren and every generation after that. This is existential risk. I'm not suggesting that anyone knows what's going to happen in the future, but we have to be prepared. It's the old Boy Scout saying, "Be prepared." We're not prepared and we're not moving in the right direction fast enough.

What's the right price? I just say you got to slam on the brakes and then see what happens. We can always adjust that price. If it seems like we're moving faster and it's costing more than necessary, which I highly doubt, then of course we can bring it down. And if things are getting worse than we anticipated, then we can move it up. But where do you start? I think you start with a heavy degree of caution and that means a high price today.

Jason Mitchell:

What lessons do you take for how to implement one successfully or unsuccessfully when you look at the European ETS markets. Do we need a Minsky moment?

Bob Litterman:

The European ETS markets have been relatively successful, although what you see is a fair amount of volatility in that price. It's been as low as, I think, 20 euros per tonne, five or six years ago. Then it went up to 80. Now it's a little bit lower. And then there's other policies within those European countries that vary across countries. I would say Europe has been leading the planet in terms of creating these incentives, so it certainly deserves credit for that.

Whether it's been high enough, then you have a problem if you have too high of a price relative to the prices outside of your jurisdiction, leakage that your manufacturing of high carbon products is going to move offshore because there's not the same incentive and the same cost associated with the creation of that. That's why Europe has been imposing its carbon border adjustment mechanism, which is required, but is also something that requires additional information about the pricing of carbon and the embedded carbon in those products. All of that has been moving forward slowly. And I give Europe a lot of credit for that, but what lessons can you learn?

Coordinated policy is a lot easier than when you're operating on your own to fix this global problem, and you have a free rider problem that it's hard for one country or one region like Europe to address. But if we can get enough countries around the world to join in and as you see, Europe's first mover has incentivized other countries to respond, that's the path forward.

Jason Mitchell:

That's true, that's true. My last guest, who it sounds like you know, Kevin Stiroh, who oversaw climate microprudential supervision at the Federal Reserve.

Bob Litterman:

Oh, yeah. Let me just say, Jason, I listened to Kevin's talk. It was fantastic.

Jason Mitchell:

Yeah.

Bob Litterman:

I chair that group, the Climate-related Financial and Macroeconomic Risk Initiative. And one of the best things I've done in the last couple of years was helped to hire Kevin to be the director of that.

Jason Mitchell:

That's great. He is fantastic. It was interesting. He observed that with diminishing US regulatory pressure, the SEC pulling back, and investors rolling back on their climate commitments and efforts, we're effectively heading into a natural experiment around sound prudential business practises. He would point to the bank specifically, but what do you think that means for the asset management industry?

Do you think existing approaches can adapt without the pressure from regulators and net zero commitments? Or does it basically just come down to incentives and we've got to figure out how to price this?

Bob Litterman:

Oh, okay. Let's be careful here and address those two things separately. First of all, I think that asset managers, and banks for that matter, have a responsibility to manage their risk appropriately, and climate risk is no different. Can they do that? Yeah, absolutely. Look at the insurance companies, they're managing their risk. I think banks and asset managers will appropriately manage their risk and asset owners will demand that. in fact, it may very well be the case, Jason, that they do a better job because they focus on the actual risk that they're taking rather than focusing on what are the regulatory requirements for reporting purposes, which may or may not have much to do with the actual risk itself. I'm pretty calm about that pullback.

They can't solve the problem themselves, as we've discussed. You need to have governments creating the appropriate incentives and then everyone moves in the right direction. Otherwise, you have inappropriate incentives. And I like to quote the work that the IMF has done. Every couple of years, they write a report talking about the implicit subsidies to fossil fuels. It's incredible. The last report, which was a couple of years ago, suggested that there was a $7 trillion global subsidy to fossil fuels. T, trillion dollar subsidy. And the subsidy in the US alone was... They estimated $700 billion in one year. Contrast that with the Inflation Reduction Act, where the government created subsidies of an estimated 400 billion over 10 years or 40 billion per year. And then of course, you had a change in the administration and that was pretty much wiped out.

The point being that government action so far has been an order of magnitude too low, relative to the implicit subsidy that comes from not addressing the externalities associated with fossil fuels. It's just incredible. And we're not going to get there until we price climate risk appropriately, until we create those appropriate incentives and reduce or eliminate those huge implicit subsidies to fossil fuels.

Jason Mitchell:

I'm sure you're aware of this, but there's this really active, ongoing debate between the merits of a Total Portfolio Approach, TPA versus strategic asset allocation. In fact, in my mind, it's pretty interesting that a number of big, they happen to be climate-aware asset owners, like NZSuper, CPPIB, and most recently CalPERS have all adopted a TPA approach. One argument goes that TPA has the benefits of dynamic rebalancing and allocation, potentially to climate opportunities, and that can react to non-linear climate risks and integrate forward-looking climate data much better than SAA. How do you weigh the two, and the pros and cons?

Bob Litterman:

I think that the way that most people would think about total portfolio management is that it reduces constraints. Rather than setting up a strategic asset allocation to different asset classes and then have those asset classes managed independently, it says take a Total Portfolio Approach. Like you said, maybe that's something that's more dynamic. Maybe that's something that includes the risk factors associated with private equity when thinking about the public equity allocation or thinking about, like you said, climate risk and how will it impact every asset class in the portfolio.

I'm a big fan of the Total Portfolio Approach. You have to recognise that strategic asset allocation is probably one step or one part of that Total Portfolio Approach. It does think about allocating risk and return across asset classes, which is not a bad thing to think about. It does think about the total portfolio volatility. That's not the only risk. And in fact, you might argue that the portfolio should think more about tail risk than about volatility, and I would agree with that.

There's a lot of aspects of the Total Portfolio Approach that I think are very useful, but it doesn't mean that strategic asset allocation should be thrown out. It just should be one of the many inputs that goes into portfolio management. And I think when you take the Total Portfolio Approach, you do create a little bit more complexity in terms of the management of the portfolio. You can't have the independent fixed income manager sitting in one room and the equity manager sitting in another. You have to get them around the same table, speaking the same language, and thinking about maybe more complicated issues than just strategic asset allocation.

Jason Mitchell:

That's super helpful. I've got two last questions. I sit on the investment committee of a UK foundation. It's not a big portfolio, but it's meaningful, where we use an OCIO for a lot of the allocation decisions. What are the practical steps an investment committee needs to take to integrate climate risk into asset allocation from your perspective? How should ICs measure success in climate-adjusted portfolios? Is it risk reduction, return enhancement, real-world impact, or something else?

Bob Litterman:

I think the OCIO model does create a little bit of additional separation, I suppose, from the investment committee and the actual management of the portfolio. When you're using that model, I think the investment committee has to be very careful to set out very clear direction to the OCIO manager and in particular with respect to climate, how that IC wants to think about it and have the OCIO manager manage the portfolio. It probably requires much clearer direction in terms of: Am I trying to achieve a risk reduction? Am I trying to take advantage of opportunities?

We haven't talked too much about taking advantage of opportunities, but as you can imagine, there's all kinds of ways of addressing climate in portfolio management. One is certainly to focus on the risks, as we've discussed, but the other is to focus on opportunities, things that have not been priced in appropriately yet, or scenarios that you think are about to play out. The IC needs to make that very explicit in the direction to the OCIO manager, and maybe even in the selection of the OCIO manager in terms of what are their capabilities, how much analysis have they done. Again, if climate risk is a concern to the IC, does this OCIO manager have the capabilities, the tools, the reporting, et cetera, that would make me comfortable?

Jason Mitchell:

That's interesting. I want to revisit your point about opportunities. As we talked about earlier, it seems like risk tends to subsume a lot of the conversation, which means that the opportunity side doesn't get enough attention. How efficient or inefficient are markets when it comes to pricing the climate opportunity dimension?

For instance, when it comes to physical risk, I've seen some pretty interesting event studies for hurricanes, where it seems like the market really has to go through a sequential process of digesting information, everything from initial NOAA data to press releases, earnings call transcripts, and company filings to start to begin to price its effects. I've also seen some pretty compelling work on identifying risk premia around water scarcity as well as extreme precipitation.

Bob Litterman:

I work with an asset management firm that's been trying to take advantage of opportunities related to climate for a number of years now, and it's not easy or obvious, as you would expect, but there are opportunities out there and we do try to take advantage of them. In many cases, the transactions costs associated with getting into and getting out of positions in relatively illiquid assets can outweigh the potential opportunities from taking advantage.

For instance, I know there's been some talk about selling homes that are in risky locations and buying homes that are in more protected locations but otherwise have the same basic characteristics. I mean, it sounds good, but you can imagine how difficult it is to get short properties and to take advantage of that. And similarly, there's opportunities in catastrophe bonds. Those are a more concentrated bet on whether or not events will occur in certain locations, but investors are already looking at those. Again, they tend to reflect the market and the market's expectations of what's going to happen in the future.

It's easy to look back and say, "Oh, there was an opportunity.", much harder to look forward and say, "All right, here's how I'm going to take advantage of this opportunity." But having said that, one of the areas where we found a lot of opportunities are in the compliance markets for carbon, the European trading system, there's the UK system, there's the RGGI states and the California, Washington State, and other countries around the world that are trading these allowances and futures on these allowances. If you think of the underlying allowances and the futures as two separate assets, the spread there moves over time and then one market versus another market.

And you can look at the underlying causes of these changes in the markets and try and take advantage of the various things that are driving them, the energy costs, the relative price of natural gas versus coal, et cetera, et cetera. Then you start talking about the opportunities in cleantech and the opportunities, as you mentioned earlier, in resilience. There's a lot of opportunities out there that you can try and take advantage of.

Jason Mitchell:

Interesting. I've got one last question, and this is a follow-on to that investment committee question around the OCIO asset allocation decision-making. But if you were advising a OCIO building a strategic asset allocation from scratch with full climate integration, what would look different from the traditional 60/40-year endowment model? Would you recommend adding explicit climate risk tilts, like systematically underweighting certain sectors or factors? What would you do? What would that look like?

Bob Litterman:

One thing you could do is you could say, "Can I create a portfolio that has minimal tracking error and has lower exposure to high emitting companies?". Some academics have asked that question and the answer is, yes, you can absolutely do that. But it's a little bit less clear that you should do that.

That has an implicit assumption in it that those high fossil fuel assets are going to have lower returns. At least if you're trying to create a portfolio that has higher returns and lower risk, you might be getting one that has lower returns and lower risk because the standard capital asset pricing model is just an equilibrium between demand and supply for assets. And if everyone has the same information and processes it appropriately, the market portfolio is going to be the right portfolio because all those prices are going to reflect all that information that everyone has, including climate information.

In that world, the CAPM portfolio, the market cap-weighted portfolio is still optimal. So, you have to have a theory about what's not being priced in and which assets are going to outperform or underperform in order for you to make a move away from the market portfolio. And as we discussed earlier, it's not clear whether high fossil assets are going to have higher returns because they have higher risk or are going to have lower returns because they haven't yet reflected the recognition of the higher risk going forward.

Jason Mitchell:

Interesting, super interesting.

It's been fascinating to talk about how climate-risk thinking has advanced over the last six years since our last podcast, what evolving market policy and pricing signals reveal about the true cost of climate certainty, and why integrating them into investment frameworks is essential for building long-term portfolio resilience. I'd really like to thank you for your time and insights.

I'm Jason Mitchell, head of responsible investment research at Man Group, here today with Bob Litterman, founding partner of Kepos Capital. Many thanks for joining us on A Sustainable Future, and I hope you'll join us on our next podcast episode. Bob, thanks so much for your time today. This has been super, super interesting.

Bob Litterman:

Thank you, Jason. It's been a pleasure.

Jason Mitchell:

I'm Jason Mitchell. Thanks for joining us. Special thanks to our guests and, of course, everyone that helped produce this show. To check out more episodes of this podcast, please visit us at man.com/ri-podcast.